This ETF offers a unique type of exposure, allowing U.S.-based investors to tap into a corner of the Chinese stock market that has historically been beyond the reach of anyone living outside of mainland China. PEK invests in A-Shares, securities that are traded on the Shanghai and Shenzhen Stock Exchanges in renminbi. Accessing A-Shares brings some potentially exciting rewards, but there are several nuances surrounding the manner in which this exposure is achieved that investors should understand and consider.

Under The Hood

Historically, the Chinese government had placed restrictions on A-Shares, preventing foreign individuals and organizations from buying these securities in an effort to restrict the movement of capital into and out of the country. In recent years, however, these restrictions have begun to ease. In 2002 Beijing launched the Qualified Foreign Institutional Investor (QFII) program, which allows approved foreign institutional investors to access the A-Share market. More than 100 QFII applications have been approved, with many large financial institutions now allowed to purchase A-Shares. Even with that approval, there is a limit to the investment that can be made (currently $1 billion).

Van Eck, the issuer of PEK, has not yet received QFII approval. So in order to achieve exposure to the A-Shares market, this fund has entered into counterparty agreements with firms that have received these licenses. Unlike all of the other ETFs profiled in this report, the underlying holdings of PEK do not consist of equity securities. Instead, PEK holds total return swaps that are linked to the CSI 300 Index, a benchmark that includes hundreds of A-Shares.

PEK offers a way to invest in Chinese companies that are not included in many other China ETFs. A-Shares account for a massive portion of China’s equity markets—nearly 75%–meaning that most investors access only a small segment of the Chinese economy. While many companies listed on the Shanghai and Shenzhen Stock Exchanges are also available on other exchanges (e.g., as H-Shares or Red Chips), there is a sizable universe of companies that are only accessible to Chinese citizens or QFIIs. There are nearly 2,000 stocks listed on the Shanghai and Shenzhen exchanges, while the H-Shares market includes only about 250 securities and the N-Shares market includes about 430 stocks.

Moreover, Chinese companies listed on international exchanges tend to be more mature firms that generate revenues from global operations. The A-Shares market, on the other hand, is more likely to include younger Chinese companies that are driven by domestic consumption, and as such may be more of a “pure play” on the Chinese economy. Examples of companies available through the A-Share market include SAIC Motor (China’s largest auto company), Kweichow Moutai (a popular Chinese liquor brand), and China Pacific Insurance Group (the fastest-growing insurance company in the country).

Pros

The exposure offered by PEK is unique; this fund gives access to Chinese stocks that most U.S.-based investors would be otherwise unable to hold. An argument can be made that China exposure that doesn’t include the A-Shares market cannot be considered to be truly well-rounded. For investors seeking access to the “real” China, PEK is certainly worth a closer look.

Cons

The techniques used to achieve exposure to the A-Shares market may have some drawbacks. Because the underlying assets of PEK are not stocks but rather total return swaps, investors are exposed to some counterparty risk (Credit Suisse Securities (Europe) Ltd. is the counterparty in this case).

There is another potentially serious outcome of the swap-based structure. As a result of the artificially limited supply of A-Shares exposure, the demand for these securities is often considerably greater than what is available on the open market. That means that the creation/redemption mechanism that generally keeps the market price of ETPs in line with their NAV breaks down in the case of PEK; this ETF often trades at a significant premium to NAV.

Investors in PEK will be impacted not only by the change in value of the underlying stocks and the value of the Chinese currency relative to the dollar, but also by changes in the premium at which this fund trades. Further inflation of the premium would enhance returns, while a decrease in the premium or even an inversion to a discount would erode performance.

Final Verdict

PEK is certainly an intriguing product, as this ETF offers an opportunity for U.S. investors to hold Chinese stocks that the other China ETFs simply cannot access. The inclusion of A-Shares as part of a China strategy certainly results in a more complete exposure profile, and may enhance the long-run return potential. But this fund comes with some very unique risks; investors considering a position in PEK should be certain to understand the nuances of the swap-based portfolio before establishing a position.